Economic Ordering Quantity (EOQ)

The Economic Order Quantity (EOQ) is the number of units that a

company should add to inventory with each order to minimize the total
costs of inventory—such as holding costs, order costs, and shortage
costs. The EOQ is used as part of a continuous review inventory system
in which the level of inventory is monitored at all times and a fixed
quantity is ordered each time the inventory level reaches a specific
reorder point. The EOQ provides a model for calculating the appropriate
reorder point and the optimal reorder quantity to ensure the
instantaneous replenishment of inventory with no shortages. It can be a
valuable tool for small business owners who need to make decisions
about how much inventory to keep on hand, how many items to order
each time, and how often to reorder to incur the lowest possible costs.

The EOQ model assumes that demand is constant, and that inventory is
depleted at a fixed rate until it reaches zero. At that point, a specific
number of items arrive to return the inventory to its beginning level.
Since the model assumes instantaneous replenishment, there are no
inventory shortages or associated costs. Therefore, the cost of inventory
under the EOQ model involves a tradeoff between inventory holding
costs (the cost of storage, as well as the cost of tying up capital in
inventory rather than investing it or using it for other purposes) and
order costs (any fees associated with placing orders, such as delivery
charges). Ordering a large amount at one time will increase a small
business's holding costs, while making more frequent orders of fewer
items will reduce holding costs but increase order costs. The EOQ model
finds the quantity that minimizes the sum of these costs.
The basic EOQ relationship is shown below. Let us look at it assuming
we have a painter using 3,500 gallons of paint per year, paying $5 a
gallon, a $15 fixed charge every time he/she orders, and an inventory
cost per gallon held averaging $3 per gallon per year.

The relationship is where

TC = PD + HQ/2 + SD/Q

• TC is the total annual inventory cost—to be calculated.

• P is the price per unit paid—assume $5 per unit.
• D is the total number of units purchased in a year—assume 3,500
units.
• H is the holding cost per unit per year—assume $3 per unit per
annum.
• Q is the quantity ordered each time an order is placed—initially
assume 350 gallons per order.
• S is the fixed cost of each order—assume $15 per order.

Calculating TC with these values, we get a total inventory cost of

$18,175 for the year. Notice that the main variable in this equation is the
quantity ordered, Q. The painter might decide to purchase a smaller
quantity. If he or she does so, more orders will mean more fixed order
expenses (represented by S) because more orders are handles—but lower
holding charges (represented by H): less room will be required to hold
the paint and less money tied up in the paint. Assuming the painter buys
200 gallons at a time instead of 350, the TC will drop to $18,063 a year
for a savings of $112 a year. Encouraged by this, the painter lowers
his/her purchases to 150 at a time. But now the results are unfavorable.
Total costs are now $18,075. Where is the optimal purchase quantity to
be found?

The EOQ formula produces the answer. The ideal order quantity comes
about when the two parts of the main relationship (shown above)—
"HQ/2" and the "SD/Q"—are equal. We can calculate the order quantity
as follows: Multiply total units by the fixed ordering costs (3,500 ×
$15) and get 52,500; multiply that number by 2 and get 105,000. Divide
that number by the holding cost ($3) and get 35,000. Take the square
root of that and get 187. That number is then Q.

In the next step, HQ/2 translates to 281, and SD/Q also comes to 281.
Using 187 for Q in the main relationship, we get a total annual inventory
cost of $18,061, the lowest cost possible with the unit and pricing factors
shown in the example above.

Thus EOQ is defined by the formula: EOQ = square root of 2DS/H. The
number we get, 187 in this case, divided into 3,500 units, suggests that
the painter should purchase paint 19 times in the year, buying 187
gallons at a time.

The EOQ will sometimes change as a result of quantity discounts

offered by some suppliers as an incentive to customers who place larger
orders. For example, a certain supplier may charge $20 per unit on
orders of less than 100 units and only $18 per unit on orders over 100
units. To determine whether it makes sense to take advantage of a
quantity discount when reordering inventory, a small business owner
must compute the EOQ using the formula (Q = the square root of
2DS/H), compute the total cost of inventory for the EOQ and for all
price break points above it, and then select the order quantity that
provides the minimum total cost.
For example, say that the painter can order 200 gallons or more for
$4.75 per gallon, with all other factors in the computation remaining the
same. He must compare the total costs of taking this approach to the
total costs under the EOQ. Using the total cost formula outlined above,
the painter would find TC = PD + HQ/2 + SD/Q = (5 × 3,500) + (3
× 187)/2 + (15 × 3,500)/187 = $18,061 for the EOQ. Ordering the
higher quantity and receiving the price discount would yield a total cost
of (4.75 × 3,500) + (3 × 200)/2 + (15 × 3,500)/200 = $17,187.
In other words, the painter can save $875 per year by taking advantage
of the price break and making 17.5 orders per year of 200 units each.

EOQ calculations are rarely as simple as this example shows. Here the
intent is to explain the main principle of the formula. The small business
with a large and frequently turning inventory may be well served by
looking around for inventory software which applies the EOQ concept
more complexly to real-world situations to help purchasing decisions
more dynamically.

ABC Analysis
ABC analysis may be seen to share similar ideas as the Pareto principle,
which states that 80% of overall consumption value comes from only
20% of items. Plainly, it means that 20% of your products will bring in
80% of your revenues.

ABC analysis works by breaking it down in the following ways:

A-items: 20% of all goods contribute to 70-80% of the annual
consumption value of the items
B-items: 30% of all goods contribute to 15-25% of the annual
consumption value of the items
C-items: 50% of all goods contribute only 5% of the annual
consumption value of the items In order to calculate the annual
consumption value of any item or items:

Value analysis
Value analysis is a problem-solving system implemented by the use of a
specific set of techniques, a body of knowledge, and a group of learned
skills. It is an organized creative approach whose purpose is the efficient
identification of unnecessary costs, i.e. cost that provides neither quality
nor use nor tool life nor appearance nor customer features.”
The term Value Analysis / Value Engineering originated in the early
days of technique development and its first approach was to increase
value, rather than to reduce costs. Therefore there was a need to analyze
value. “Value analysis approaches may assist all branches of an
enterprise-engineering - manufacturing, procurement, marketing, and
management by securing better answers to their specific problems in
supplying what the customer wants at lower production costs. Quite
commonly, 15 to 25 per cent and often more of manufacturing costs can
be made unnecessary without any reduction in customer values by the
use of this problem-solving system in significant decisional areas.”
VA/VE is an extremely powerful approach with over a century of
worldwide application and it can be applied to any cost generating areas
with equal success.
What is value-
Different customers will answer to that question in different ways. The
value of a product can be the performance of its functions or its aesthetic
beauty, when applicable and needed. As a general statement high level
performances, capabilities, emotional appeal, style, all compared to cost
is commonly what we consider as value.
Value=Function/Cost

Value Analysis is a standardized, multi-skilled team approach which

aims at identifying the lowest cost way and ensuring the highest worth to
accomplish the functions of a product, process or service. Value analysis
means to assess product functions and value-to-cost ratios, and to find
opportunities for costs reduction.
Classification and codification
Classification and codification of materials are steps in maintaining
stores in a systematic way. Materials are classified in such way that
storing, issuing and identifying of materials become easy.
Generally, materials are classified on the basis of their nature.
Materials can also be classified on the basis of quality and utility. For
example, materials may be classified as raw materials, consumable
stores, components, spares and tools. Thus classifying materials on
different bases such as nature, quality and utility is called classification
of materials.
For the purpose of identification and convenience in storage and issue of
materials, each item of material is given a distinct name. Such a process
of giving distinct names and symbols to different items of materials is
called codification of materials. Good store-keeping requires proper
classification and codification of various items of stores on stock. Stores
are generally classified either by their nature or by their usage. The
former method of classification or classification by the nature of
materials is most commonly used. Under this method of classification,
the various items of stores are divided into specific groups like
construction materials, belting materials, consumable stores, spare parts
and so on. All the items are grouped, so that each item of stores will be
conveniently codified on alphabetical, numerical or alpha-numerical
basis concept and given a distinctive store code number.
In numerical codification, each item is allotted a number, The
numbering may be straight or in groups or blocks. This method is very
suitable for those companies where the number of items are very large.In
alphabetical codification, each item is denoted by a combination of the
alphabets, for example, A for nut, B for screw and so on. This system is
not suitable if there are large number of store items. In alpha-numeric
codification, alphabets along with numbers are used for coding. The
decimal codification system is more commonly used. The number of
digits in the code will depend upon the extent of classification required.
The greater the number of details to be covered, the greater will be the
number of digits. Following are the advantages of classification and
codification of materials Quick and easy identification of materials.
Helps ensure a proper material control. Secrecy of materials. Saving of
time in material handling. Eliminating the chances of wrong issue.